What is a Defined Benefit Plan?
A defined benefit plan is a qualified retirement account that contractually agrees to pay a specified benefit at the plan holder's age of retirement. This type of qualified plan clearly defines the amount of retirement income to be paid to the account owner.
How Does a Defined Benefit Plan Work?
The defined benefit is calculated using a formula stated in the plan document; common factors incorporated in the formula are the employee's pay, years of employment, and age at retirement. The benefit is usually payable at a predetermined period of time, such as the attainment of age 59 1/2. Some plans will also provide benefits prior to the stated retirement date if the plan participant dies or is disabled.
Defined benefit plans usually pay out benefits in the form of a life annuity. This annuity generally begins at the plan's stated retirement age and ends when the accountholder dies. As an example, a specific defined benefit plan might pay a monthly income equal to 30% of the participant's average compensation. This payment could begin at age 65 and continue for the life of the participant.
Another example of a defined benefit plan is the "Dollars Times Service" plan. Popular among union workers, this plan provides a certain amount of income (benefit) each month based on the time an employee works for a company. For example, a plan offering $100 a month per year of the employee's service would provide $3,000 per month to a retiree with 30 years of service.
Why Does a Defined Benefit Plan Matter?
Unlike a defined contribution plan, in a defined benefit plan the employer assumes the investment risk by agreeing to pay the stated benefit. Investment gains or losses do not affect the benefit payable to the plan participant.
Thanks to the enactment of the Employee Retirement Income Security Act (ERISA) in 1974, most defined benefit plans are further guaranteed with insurance under a program administered by a government agency called the Pension Benefit Guaranty (PBGC).